SKY-HIGH STOCK PRICES
Market observers have noted the potential role of low interest rates in pushing up CAPE ratios. In traditional financial theory, interest rates are a key component of valuation models. When interest rates fall, the discount rate used in these models decreases and the price of the equity asset should appreciate, assuming all other model inputs stay constant. So, interest- rate cuts by central banks may be used to justify higher equity prices and CAPE ratios. Thus, the level of interest rates is an increasingly important element to consider when valuing equities. To capture these effects and compare investments in stocks versus bonds, we developed the ECY, which considers both equity valuation and interest- rate levels. To calculate the ECY, we simply invert the CAPE ratio to get a yield and then subtract the 10-year real interest rate. This measure is somewhat like the equity market premium and is a useful way to consider the interplay of long-term valuations and interest rates. A higher measure indicates that equities are more attractive. The ECY in the U.S., for example, is 4%, derived from a CAPE yield of 3% and then subtracting a 10- year real interest rate of -1.0% (adjusted using the preceding 10 years’ average inflation rate of 2%). We looked back in time for our five world regions – up to 40 years, where the data would allow – and found some striking results. The ECY is close to its highs across all regions and is at all-time highs for both the UK and Japan. The ECY for the U.K. is almost 10%, and around 6% for Europe and Japan. Our data for China do not go
We cannot know how the COVID-19 pandemic will end... a key takeaway of the ECY indicator is that it confirms the relative attractiveness of equities, particularly given a potentially protracted period of low interest rates. It may justify the FOMO narrative and go some way toward explaining the strong investor preference for equities since March. in both regions are skewed toward the technology, communication services, and consumer discretionary sectors, all of which have benefited from the major narratives of the COVID-19 pandemic, which may partly explain their higher CAPE ratios relative to other regions. level prior to the start of the COVID-19 pandemic... In fact, it is now back to the same level as the high of 33 in January 2018. There are only two other periods when the CAPE ratio in the U.S. was above 30: the late 1920s and the early 2000s. China’s CAPE ratio is also higher than it was prior to the pandemic. The stock markets As for Europe and Japan, their CAPE ratios are largely back at their pre-COVID-19 levels, while only the United Kingdom is still well below its pre-pandemic level and longer-term average. Notably, these regions have lower exposure to the technology, communication services, and consumer discretionary sectors.
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December 2020
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